What Is Risk?

Chances are, the topic of investment risk was not a
popular cocktail party discussion during the 1995 to early 2000 bull
market. Investors basked in the glow of
the returns of their Internet and Telecom funds and talked very little of the
trivialities of standard deviation and volatility. However, as these funds, held so dear just a few short years ago,
are shutting their doors, the topic of risk in the investment arena has once
again been brought to the forefront. It
is a topic not understood by many investors, and one that is absolutely
essential to evaluating every investment opportunity that may arise.

Typically, risk is defined as the degree of uncertainty
associated with the return of an asset.
Yet risk comes in many shapes and sizes, and the financial community has
found a dizzying number of methods to quantify and develop techniques to
attempt to keep it at bay. What follows
is a short discussion of the varying types of risk as well as ways to measure
risk on the whole.

Unsystematic Risk:

Unsystematic risk is also known as diversifiable risk
because it can be mitigated through diversification. Unsystematic risk refers to the business risk inherent in all
companies. This type of risk can be
boiled down into factors including but not exclusive to credit risk (the
ability or inability to obtain adequate financing), business cycle risk
(relating to the typical ebb and flow of industry forces) and threats posed to
cash flow generation.

Systematic Risk:

Unlike its cousin, systematic risk cannot be diversified
away, and is caused by much broader forces.
It is typically broken into four subcategories. They are as follows:

·
InflationRisk – The risk of investing
and not providing a higher return than annual consumer price increases (CPI)

It is important to note that equities are not the only
asset class that is exposed to a certain degree of risk. Your grandmother’s portfolio of short-term
Treasury Bills and 3-month CD’s is anything but risk-free if it cannot outlast
inflation. Correspondingly, even the
astute investor, attempting to eschew risk with his newly-minted bond portfolio
may be in for a rough journey if interest rates rise to their historical levels
of near six (6%) percent.

Quantifying Risk:

As with most abstract topics, the financial community has
spent long hours attempting to quantify risk, which takes an otherwise abstract
topic and boil it down to a single number.
Generally speaking, investment analysts use only two methods to
scrutinize risk, beta and standard deviation.
Beta refers to a security’s overall sensitivity to market conditions as
represented by the S&P 500 for example. For instance, if a prized stock in one’s portfolio sports a beta
of 1.5 and the market returned 10% for the past year, in theory, the stock
would have netted a 15% gain. Likewise,
if the market had plummeted by that same amount, the stock would have lost 15%
for the year. Beta is generally
considered the preferred measure of risk in the equity markets when measuring
domestic equities, especially by the academic community.

A second risk measure, standard deviation, looks instead
at the volatility of a given financial instrument. It provides a range of expected returns based on past
performance. For example, the S&P
500 since January 1, 1926, has a historical standard deviation of approximately
twenty. This means that over that time
frame, the S&P 500’s returns fell within a range of 20% above and 20% below
its historical mean approximately 10.7% two-thirds of the time. As a result, because it is more accurate as
a gauge of portfolio volatility, it is generally used frequently to quantify
risk for mutual funds and other such portfolios of securities.

Risk is manageable to a degree. However, you really can’t avoid or minimize risk unless you
understand the many types of risks there are and what they are.

For further
information, contact Louis P. Stanasolovich, CFP™ at (412) 635-9210 or e-mail him at
legend@legend-financial.com.